The U.S. Securities and Exchange Commission (SEC) approved a new form of “Cash Management” exemptive order under the Investment Company Act of 1940 (the 1940 Act) on April 3, 2023. The approved order allows the company that received the order to hold unlimited amounts of “capital preservation instruments,” and also to invest to a limited extent in other types of investments, without being deemed an “investment company” for purposes of the 1940 Act. This order is the first so-called “Cash Management Order”1 that the SEC has issued in a few years.
Wilson Sonsini represented the company in connection with its application for relief, and in that role worked closely with the staff of the SEC on this revised—and we believe more standardized—template.
The 1940 Act and Problems Raised for Tech Companies
Under the 1940 Act, a company that holds more than 40 percent of the total value of its assets (excluding cash, cash items, and U.S. federal government-backed securities) on an unconsolidated basis in “investment securities” meets the definition of an “investment company” and may be required to register with the SEC under the 1940 Act. “Investment securities” include most securities other than U.S. federal government-backed securities and securities issued by a company’s majority-owned subsidiaries that are themselves not investment companies.
While the 1940 Act is primarily intended to regulate companies such as mutual funds, it sometimes creates regulatory headaches for technology and service companies that hold significant amounts of cash and few “hard” assets, and thus have a relatively small denominator in their calculations under the 40 percent test. In such cases, plain-vanilla cash management instruments like certificates of deposit, investment-grade corporate bonds, commercial paper, and others may cause a company to “fail” the 40 percent test. Most operating companies could not function under the substantive restrictions of the 1940 Act and need to monitor their 1940 Act status.
Although there are a number of exceptions from investment company status under the 1940 Act even when a company “fails” the 40 percent test, tech companies often cannot rely on those exceptions. In those cases, companies may want to consider whether it makes sense to apply for a Cash Management Order.
Terms of the Cash Management Order
Subject to certain conditions, the Cash Management Order issued to the company allows it to invest without limit in “capital preservation instruments” such as investment-grade corporate bonds, commercial paper, certificates of deposit, and other highly liquid, investment-grade securities. This can provide a tech-based operating company additional latitude for investing without calling its investment company status into question.
The Cash Management Order issued to the company contains three conditions that differ somewhat from the conditions included in prior Cash Management Orders, and that we expect to be standard conditions for future orders:
- the company will continue to use its accumulated cash and securities to support its primary business;
- the company will refrain from investing or trading in securities for speculative purposes; and
- no more than 10 percent of the company’s total assets will consist of investment securities other than capital preservation instruments.
The final condition in particular may be an important consideration for companies considering an application for a Cash Management Order. “Total assets” under this condition exclude cash items, securities issued by registered money market funds, and U.S. federal government-backed securities. Because companies typically hold at least some amount of these excluded assets, in most cases “total assets” will equal something less than the total assets reflected on a company’s balance sheet. For companies that hold relatively large amounts of excluded assets, “total assets”—and thus the 10 percent basket for noncapital preservation instruments—could be relatively small. In the tech industry in particular, companies often make strategic investments in commercial partners or to otherwise support the industry. Without a Cash Management Order, they can, in theory, hold up to 40 percent of their total assets (minus cash, cash items, and government securities) in these investments—much more than 10 percent—but this amount is reduced by the amount of any other securities, including cash management investments, they hold.
Companies should consider whether the 10 percent limitation will be problematic for their plans,2 and balance that limitation with the trade-off of being able to make unlimited investments in capital preservation instruments. Notably, the 10 percent bucket may in theory be inflated by holding cash management instruments such as commercial paper or investment-grade corporate bonds instead of cash and government securities, although presumably with somewhat greater investment risk.
Applying for an Order
For companies that seek additional flexibility to invest in capital preservation instruments, seeking a Cash Management Order may be an attractive option. Based on our experience with the company’s Cash Management Order, Wilson Sonsini is well-positioned to advise on these and other requests for exemptive relief under the 1940 Act.
Standardization of Cash Management Orders by the SEC may be a prelude to an eventual rule proposal, which would be welcomed by many tech- or services-based companies. Any actual rule is likely several years away at the earliest, however, and so it often will still make sense for companies to consider seeking one.
Please direct any questions regarding these topics to Wilson Sonsini partner Amy Caiazza, senior counsel Marc Foster, or another member of the firm’s fintech and financial services practice.
[1] The first Cash Management Order was provided to Applied Materials, Inc. in 2005. Since then, the SEC has issued similar orders to (among others) Hutchinson Technology Inc., RealNetworks, Inc., Dolby Laboratories, Inc., and Exact Sciences Corp., with the most recent prior to the order discussed in this alert issued to Snowflake, Inc. in 2020.
[2] This can be a particular problem, of course, if the value of an investment in a private company increases quickly and thus creates issues under the 10 percent threshold, especially where the market for the investment is illiquid, such that it will be difficult for the investing company to sell it to ensure compliance with a Cash Management Order.